Why I can’t pick winning stocks, and you can’t either

Indexing vs. active management is always a fascinating debate; at least for us stock geeks with nothing better to do. Over the decades I’ve been on both sides of it at various times. For a very long time I laughed –ha, ha, ha, ha — at the indexers. I made all of the arguments, and then some.

After all, if you just avoided the obvious dogs you’d do better than average, right? Who would be stupid enough to own GM a couple of years ago? Or Ford? Opps. Better forget about Ford. Hindsight is a beautiful and perfect thing.

Convinced I could win this game, after all I’d just bought a stock that tripled, I even took a major pay cut to join an investment research firm mid-career. http://jlcollinsnh.wordpress.com/about/ There I was, surrounded by exceedingly bright people. Each focused on one, maybe two industries and perhaps 6-10 stocks. More than one had been honored in the trade press as “Analyst of the Year” for their work.

They knew each of these companies inside and out. They knew the top executives. They knew the middle-managers and the front line people. They knew the customers. They knew the suppliers. They knew the cute receptionists. They spoke to them all weekly. Sometimes daily.

They still didn’t get info before anyone else (that’s insider trading, fool proof and, ah, illegal). But they did know exactly when and how the info would be released. Of course, so did every other competent analyst around the world. Any new information was reflected in the stock price within minutes.

If you’ve worked in a major corporation it is not hard to see why. The CEO and CFO work with internal forecasts from their teams. The process looks something like this:

Salespeople are required to forecast what their customers will spend. Since these buys are rarely locked in far in advance, and can be cancelled anytime, nothing is certain. Add to this all the pending business that may or may not come to fruition and basically you are asking the field salesperson to predict the future. Typically they are not clairvoyant. So, of course, they take a guess.

These guesses get passed on to their managers, who are also not clairvoyant, and who now have their own forecasts and decisions to make. Do I take these sales forecasts at face value? Do I adjust them based on knowing Suzy is an optimist and Harry always sees dark clouds? So, of course, they take a guess and pass it on to the next layer of management.

So it goes until all these guesses on the inherently unknowable future are consolidated into the nicely packaged budget/forecast binders presented to top management. More often than not, after one look, they’ll say: “This is unacceptable. We can’t present this forecast to Wall Street. Go back and revise these numbers.” Back down the chain it goes. Maybe multiple times, and each time the numbers get a bit further from reality.

Now predicting the future is a dicey proposition for even the most gifted psychics; and they are not burdened with this process.

Suddenly my enormous stock picking hubris was clear. Somehow reading a few books and 10ks was going to give me an edge? Over not only the professional analysts who lived a breathed this stuff all day every day, but also the executives who run the companies in question? I could succeed where they could not?

Suddenly I realized why even rock star fund managers find it almost impossible to best the simple index over time.

There is a reason names like Buffet and Lynch are so revered and well known. There are also reasons more fortunes have been made brokering trades than making them.

That’s why I’m now an indexer. If you choose to try to best the averages, God Bless and God Speed. You may well be smarter and more talented than I. You are most certainly likely to be better looking. I’ll look for your name along with Warren and Peter’s in the not too distant future.

I extend the same to all those folks I’ve met in Vegas who assure me they have bested the house. I listen, gaze up at the billion dollar casinos and reflect on how many smarter, more talented and better looking people there are than me.

Oh, and that stock that tripled? Well, even a blind squirrel……

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Comments

Yep, those glittering Vegas palaces were all funded by people who thought they could beat the house. Of course if you head over to the Poker room, you’ll find people who can win consistently with skill, because they have found ways to invest their money in situations where they have a statistical advantage.

Most Poker players also lose, admittedly. But some win – year in, year out.

I used to play in a regular game in Chicago and made a pretty good dime or two in the process. It is the only “gambling” I’ve ever enjoyed because:

1. It is a game of skill. Statistically, every player will receive the same number of winning and losing hands over time. The guys who walk out with the money are the guys who know which is which and how to play them.

2. I didn’t have to be the best player at the table to make money. This was important as I was rarely the best player. In poker the top two or even three players take home the cash.

I remember playing in a high stakes game in Vegas for the 1st time. It became clear quickly that four of the eight seats were occupied by pros. They spent the night cleaning out the tourists who’d sit down for the 20 minutes or so it took them to bust out.

The pros hated me. I wasn’t good enough to win but I was good enough that it took them all night to clean me out. That made for a far less productive seat.

Hello Jim,
I love your articles and agree with most of them. I’m on the fence on this particular one.
I’m currently following AAII’s model shadow stock portfolio which has worked great for me since I started following it in the past couple of years.
I’m young and have been investing only a few years in the market and I’ve been seeking the answer to this question – should I invest in individual stocks or index funds.
AAII’s shadow stock portfolio’s return since inception in 1995 has been 17.9% vs S&P 500’s 9.43% for the same period. It seems to me that their model certainly seems to be working. I would like to know your thoughts as well. Do you still believe it’s better to invest in VTSAX vs just shadowing AAII’s model stock portfolio?

Glad you love what you are finding here and hope you continue to read more.

This post is really at the core of what I believe and discuss here. It is not just my opinion, but the conclusion of an ever increasing body of research. Even Warren Buffett, perhaps the best stock picker of all time, is on board with the concept of indexing.

I am unfamiliar with the AAII model you mention, but there are countless investments out there striving to out perform the market. Some do for some periods of time, and they are endlessly creative in presenting their track records in the most favorable light.

But every prospectus carries this warning: “Past performance is not a guarantee of future results.”

The are both the truest words in these documents and the most ignored.

It is easy to look back and find the funds and portfolios that have outperformed in the past. It is impossible to predict which will do so in the future.

That said, it is great AAII has worked well for you so far and I completely understand the temptation to continue. It just seems so reasonable. It took me years to accept how vanishingly difficult it is to outperform the market and how rare and fleeting those that seem to are.

I’ve been reading your blog for a number of years but this is my first comment. Thanks for all your efforts.

This is a great topic and rarely discussed. I have a few personal theories that others may or may not share. I would agree that the external stock price is almost completely unpredictable as it depends on the market participants and their level of the analysis of the company. For example, if they have done a great deal of analysis you would expect closer tracking between the quoted stock price and internal earnings than if the market participants just rely on staring at meaningless charts and momentum following. I also think that if the company pays a sizable proportion of it’s profits out as a dividend you would expect a stronger coupling between what’s happening internally on the financial statements and the external stock price.

For an investor that is concerned primarily with receiving growing dividends (I don’t see the point in stocks that don’t pay me), the unpredictable stock price growth can become an irrelevance as long as earnings are growing internally and cash flow is fine. It is possible to geometrically predict (The rarely discussed “T-model”) the growth of both the internal earnings and external dividend to an extent if a certain amount of stability can be assumed in the financial statements. For example, a P/E of 10 and a 50% payout ratio should lead to a 5% dividend payout and 5% growth in equity, and hence 5% growth of the dividend (assuming further re-investment in the business does not hit diminishing returns) each year as a rough estimate. Obviously the next year may not be exactly the same, but concentrating on how much earnings you are buying and the dividends rather than the stock price behavior is a much more predictable animal. I like to have a reasonably stable “base” income from dividends whilst still allowing to reap additional (though completely unpredictable) capital gains for further rewards if the stock gets bid up beyond reason. I only sell then if I think I can buy more earnings and dividend payout with an alternative issue.

Thanks for the other link. I also like the Dividend Mantra blog. Not sure I can make FinCon as I am in Japan and have an old house to restore this year. But would be good to share more ideas. Sorry for the long post, but here are some further thoughts on your “Dividend Growth Investing” article:

Point 1. With vanishingly rare exception Index Investing bests all other methods.

I think that the pros can’t do active investing because of both the size disadvantage and career risk. Whilst it is not common, I believe active investing possible from what I have read and from my own experience. See “The Superinvestors of Graham and Doddsville”. This was Buffets excellent rebuttal of efficient market theory. It’s an amusing (and short) read talking about how all the Graham students did well beyond the odds.

It is possible to find very good returns in the market but easier when small cap companies are considered. This rules out the big guns and massive funds as they have too much scale to invest in those small companies. I also think most studies on the subject recommending ETFs have only concentrated on professional funds, whos size may still be too large. The financial industry would also have a vested interest to push “passive investing” and they fund all of the university professors! The only Economists I believe are not frauds are from the “Austrian School” which was the economic thought before the Keynesians took over around the 1960’s.

For mass market, where the majority of society needs to invest, I agree the only possible way is with index funds. Active investing is not possible if your scale is too large and moves the market for particular stock. This must be true by definition, because the mass market is basically all of the investors, but if you succeed in purchasing under-valued securities then those must have been sold by others at too low a price. It’s a zero-sum game and there unfortunately must be winners and losers. The winners have done the most homework. If everyone has to invest, then it must be sub-optimal as they will have to buy an index containing both overpriced and underpriced companies.

Point 2. Taxable event. This is of course OK if you are already retired. But very difficult if you are working at the same time in UK, US or Japan where taxes can hit over 40%. Some other more economically free countries (Hong Kong or Singapore) do not tax dividends. As a result companies in those countries tend to have higher dividend payouts. In those countries dividends of up to 8% are quite common even for large REITs as of 2014. The financial press in those countries is entirely less useless than in the west.

I think the trend towards high taxes on dividends in the western countries has resulted in a great decoupling between the stock price and financial statements due to the loss or reduction of dividends for the most part over the last 50 years. Books in the 1940’s emphasized dividends a lot as “proof” of real profits not suspect to accounting shenanigans. For example Graham and Dodd’s “Security Analysis” is an easy read and makes a lot of sense rather than modern books mentioning the “efficient markets” mumbo jumbo that seemed to arrive around 1950.

Point 3. Dividends do cause a reduction in company value.

This is true, however consider that:

– It is necessary to have some income to live off. Selling when others are fearful is bad.
– Dividends are more stable than stock prices.
– Dividends paid in a time of turmoil allow you to re-invest at fire-sale prices.

In some cases, it may not be possible for the business to expand easily (marginal return of further investment in the capital of the business is less than the existing return from the business) in this case it is better to pay out all the profit to the shareholders. I think this is referred to in the “Security Analysis” book. It discredits the “empire builders” who want to re-invest all of the profits back into the business on grand (but possibly unproven) schemes to grow the company. This might be better for their self aggrandizement but if it lowers the average ROE it was a poor decision for the shareholder. Some business should just stay the size they are.

Regarding your comment: “The price you pay is lower potential growth.” That is true, however if the company that paid out that dividend still offers the best return for you, then you can still buy more of their stock with the dividend and create growth this way from all of the profit (paid out plus retained). You have a choice, unlike if all of the profit is retained.

As I understand and agree, the issue of dividends getting taxed at a punitive rate of income tax is an enormous problem if you are working as an employee, and don’t live in Hong Kong or Singapore. In this case I do understand the argument against dividends. Unless you can ship all your capital to Bermuda using a yacht full of gold bars 🙂 Most of the elites in the US have probably taken such measures.

I think given two companies of otherwise identical financial ratios, the one with the larger proportion of profit paid out as a dividend should have a better correlation between what the financial statements say and what the stock price does. The one without a dividend will have a looser “coupling”. But in the end even a company with no dividend should have the stock price converge eventually due to other events such as corporate takeover, which should force the true worth to appear in the stock price as highly numerate individuals are involved in those deals. It’s just that it will be more of a wild ride and could take many years. And during that time you can’t collect any benefit if the market goes the wrong way, even if internally everything is good with the company. So if you have already retired switching from non dividend paying to dividend paying stocks seems like a good proposition.

Great Post Jim. I think you’re right for the most part. You either have to be fully diversified and hope that the market goes your way. If you are going to invest actively, you must spend quite a bit of time doing it and just make really good investments.

I’ve done a fairly good job over the years but I wouldn’t call myself a market sage. Often times I’ll go years between investments where its sitting in cash or liquid bonds. I think the key is to make a few good investments and watch those investments very closely. Warren Buffet has said something to that effect, I think. So I’ve found that its best to invest in what you know in and with as much as a margin for error as possible so that when you’re wrong you’re THAT wrong. Keep in mind that I spent 4 years in college learning about investments then preceded to work in the Investment banking business for 2 years after college. So for the average Joe, you’re probably right.

It seems like as time goes forward that there are fewer and fewer gems in the public market. The market for private equity seems to be gaining momentum and due to regulatory restrictions a lot of companies don’t see the benefit in going public. I’ve found that most of the good investments in public markets now come from special situations with overzealous selling in the market with a short time horizon outlook.

There’s still hope for getting decent returns in the Public Stock Market, it just might not be as “easy” as it was in the past with less asymmetries of information(proliferation and speed of information spread through the internet) and the rise of private equity markets.

That being said, I love your blog and found it through a manifesto quote you posted on Mr. Money Moustache. Thanks for all the insight, love your writing.

Hi Jim. I just recently stumbled upon your blog. I sure do wish I had read all of this ten years ago. But here I am, trying to straighten things up. With that said, given the topic at hand, how would one argue/debate with a broker at a major firm, say Merrill Lynch or American Funds? 1) There have been personal relationships developed and 2) These guys truly believe that what they’re doing is better than the competitors. But when stats suggest otherwise, and my gut says get into Vanguard Indexes, how do I backpedal out of these snakepits w/o destroying a friendship, and more importantly knowing that I won the debate? Thanks for your help and thanks for all of these great posts.

Henry,
I know how that can be. I have a few friends who are financial advisors. Most of them aren’t that smart and simply are good at the financial sales game. These people potentially have cost you thousands of dollars, maybe even more. they probably know that index funds are cheaper and better than their products but they don’t make as much money putting clients into index funds. They didn’t have your best interest at heart and more their wallet. Perhaps they really do believe in their product. Look at it this way, Would you be worried about how a thief felt if you called him out on stealing thousands of dollars from your wallet? It’s the great American deception. 401k fees. With your friends, ask them exactly what all the fees are and compare to vanguard. Then compare the returns net of fees. More Than likely they will be beat. Then say that you’d like to stay with them but it’s costing thousands of dollars to do so and it just doesn’t make financial sense. Those funds take hefty fees whether you make money or not. If you have a 500k portfolio this potentially $5,000+ dollars a year. Good luck!

1. When I was first starting out in business and sales, I called on a customer with my boss. They were about the same age and had clearly known each other for years. They greeted each other as old friends and talked about many personal things. I was impressed with how close their personal friendship was. When we got on the elevator to leave and were alone, my boss turned to me and said “If that son of a bitch doesn’t spend at least $X with us this year I’m never fucking talking to him again.”

2. They might very well be true believers in what they are selling. The financial firms that hire them and/or persuade them to sell their products work very very hard on selling them first. True believers are, after all, the most persuasive sales people. Or they might be aware of all the research that shows just how much more effective low cost index funds are, and simply not care. After all, the other stuff is what gets them paid.

If you pull out, you’ll find out quickly how real their personal relationship with you is. My guess is it will be the end of the friendship which, of course, means it wasn’t a friendship at all.

As for winning the debate, why bother?

One thing these guys are likely to be very well trained for and very good at is persuading people to stay with them. In addition to having more training for the debate, they will also have far more practice than you can hope for. Remember, the winner of any debate isn’t the person who is right, it is only the person who is the better debater. There is no need for you to engage in a debate with them, let alone win it.

If you are ready to leave, you don’t have to explain yourself to them. You don’t have to convince them that it is a good move; and you never will. You only have to convince yourself and then do it.

Frankly, there are simple edges given to buyers of small stakes in companies vs. buying indexes.

Advantages:
1 – Fees – I buy stocks in whole lots ($50 per stock per month via sharebuilder – equal-weighting mostly but I have no firm rules). I pay $144/year to do this, and as my portfolio grows in assets I still pay the say amount. Any index fund will charge a fee that is based on assets under management, and this inherently grows over time with the size of your savings. I prefer the fixed fee as it decreases the expenses over time rather than increases. If I ever prefer to do no investing at all and take a year off, I won’t pay anything at all. The cost curve is tough with 0.05% expense ratios but it moves in my favor after just $30k in assets. Imagine how much you save with $600k in assets.

2 – Emotion – True investment means picking a business you feel that you would like to offer your cash to for them to use for growth, and being comfortable with that transaction. This is a very personal choice, and offers a level of commitment that should be the principal behind investing. Emotionally, this offers a more stable foundation for wealth-building. Like having equity in the company you work for, you have skin in the game and this affects your choices. Buying an index fund offers no incentives. You are an absentee landlord, collecting small rent checks. If you do not want to get intimate with the ownership your have in specific companies and prefer autopilot, then really you shouldn’t be in the stock market, you should have your money in bonds. The reason most investors freak out and make dumb decisions with their stock holdings is because they have this sense of non-ownership, and the poor incentives that come along with that.

Overall, it’s sad that public companies, stock ownership, stock markets, and the actual concepts underlying the whole system are divorced completely from what investment is truly all about. It’s not about you. Get over it. It’s about all of us, and providing the capital needed to triumph over the human conditions that defeat us daily. You should be picking your own winners (whether their stock wins is different – vote with your dollars by investing in companies you believe in). Allocating to the broad market is un-ethical since you are just piling more money on those that already have the most (due to market-cap-weighting of the S&P or MSCI, etc). Apple doesn’t need any more of your cash to thrive in the world, but if you happen to think that the team they have there can rally to new important human needs then give them your money. They do not though, need a disproportionate amount of it compared to everyone else.